Question

For each of the following separate situations, determine the associated cost of inflation.

(1) shoe-leather costs; (2) money illusion; (3) menu costs; (4) future price level uncertainty; (5) wealth redistribution; (6) price confusion; or (7) tax distortions.

1. Wages of computer scientists always rise because our economy needs more and more computer scientist over time.
2. A grandpa talked to his grandson, “When I was young, everything was so cheap. Now everything is too expensive.”
3. Mary does not want to lend money to Simon even though Simon will pay her an interest rate of 3% per year.
4. Tom does not like withdrawing money from an ATM as he always forgets the password.
5. Frankie can make a huge gain if she sells her house, but she is not willing to do so.
6. Carlos sells pizzas. He has kept the prices constant for 3 years even though CPI has been increasing tremendously.

Answer 1

Ans: Wages of computer scientists always rise because our economy needs more and more computer scientist over time - Money illusion because people view wages in nominal terms not in real terms; it occurs when people confuse the changes in nominal prices with real prices because computer scientists wages have risen but price level have risen over time we can't say whether their wages have risen in real terms or not; in reality wages should be adjusted for inflation. This is the money illusion cost associated withthe inflation because people view increase in wages in nominal terms.

A grandpa talked to his grandson, “When I was young, everything was so cheap. Now everything is too expensive.- the cost associated with inflation is future price level uncertainity; this indicates that the price level uncertainity has increased over the period of time; In future times the price level has become more uncertained; the volatity of price level increases as the inflation level increases;

Mary does not want to lend money to Simon even though Simon will pay her an interest rate of 3% per year. The cost associated with inflation is wealth redistribution; because unequal unexpected inflation can serve to redistribute wealth in the economy; not all the investments are indexed to inflation; higher than the expected inflation makes the value of debt lower in real terms;thus unexpected and higher inflation can make Mary's investment decline in real terms. Thus she does not want to lend. as it can lead to wealth inequalities.

Tom does not like withdrawing money from an ATM as he always forgets the password - the cost associated with this is shoe - leather cost refers to the cost of replacing shoes more often due to increase in the number of trips to banks, thus individuals prefer to keep their money in the form of cash as they have to go to banks for most of the times to do transactions so Tom wants to keep as much as cash as possible.

Frankie can make a huge gain if she sells her house, but she is not willing to do so - the cost of inflation is tax distortions because if she sells the house then she will make a huge capital gain and capital gains are taxed so if the inflation level is high it can lead to tax distortions; thus leading to much higher effective tax rate on capital gains when inflation is present than stated nominal rate.

Carlos sells pizzas. He has kept the prices constant for 3 years even though CPI has been increasing tremendously. the cost of inflation is menu costs refers to cost of printing new menues, relabelling etc. as a result of much higher inflation because changing prices imply changing of old menues and all; Carlos has kept the prices constant because by changing prices for Pizzas require higher cost of changing menues; he has decided not to incur the menu- cost associated with the inflation.